15 September: When the US Fed Called Time on Lehman

Having been in the market place for 53 years I suppose 15th September 2008 has to be the worst day in the history of banking by a country mile. Erin Callan, the FD of Lehman Brothers had been less than economical with the truth as to the robustness of Lehman’s balance sheet. Nor, as I recall, was CEO Richard Fuld as helpful to the market as he might have been. In fact it was all over for Lehman, with this bank loaded up with humongous amounts of bad sub-prime lending, little did the market know what was going to unfold! Lehman was largely regarded as the largest bond house on Wall Street. On 14th September 2007 Lehman’s share price stood at $59.50, valuing the share capital at $41 billion. When Lehman went down the share price was a derisory 21 cents. When Lehman Brothers filed for bankruptcy with $639 billion in assets and $619 billion in debt, Lehman’s bankruptcy filing was the largest in history. With the writing down of assets, losses close to $600 billion would have been incurred.

US Treasury Secretary Hank Paulson had been very comfortable in conjunction with FED Chairman Bernanke in getting JP Morgan to bail out Bear Stearns for $10 a share and Washington Mutual for next to nothing. Shortly afterwards AIG was shored up with a $182 billion bail-out facility. However the moment Lehman came up with its ‘Oliver Twist begging bowl’, Paulson threw the towel in – ENOUGH he cried and that sent the biggest shock waves across the international banking system. Everyone had erroneously assumed that Paulson would come galloping over the hill like a white knight in shining armour. Consequently, all the trading banks never had a chance to ‘cross’ outstanding trades, which could have mitigated some of the gargantuan losses rather than exacerbating these losses, which the banking sector was forced to absorb.

Eight years on the banking sector has still not fully recovered. Though the market is grateful for small mercies – massive quantitative easing, which bought time and restored confidence, regulation’s hob-nailed boots left their wheels of pain across the backs of every bank in the world. It is fair to say that the restoration measures taken by the FED, US Treasury and the ‘Dodd Frank Act’ with considerable cajoling from Volcker enabled the US banking system to recover more quickly, but at a price. The US regional bank is not as prevalent as it was; so many went by the wayside. With the regulators all over the sector like a bad rash, banking will never be the gravy train it once was, though US banks are making a better fist of it than other parts of the world. Regulation and capital requirements are so tough it is hard to see the kind of increase in valuations that were made in 2009/10. Let’s face it, apart from in the US the gains made in other parts of the world have been more or less surrendered.

The one criticism I have, is, that the authorities have been quick to impose painful fines for transgressing banks, but no prohibitive jail sentences for the real offenders who abused their privilege. Traders and middle ranking mangers have been easy pickings for the regulator. That is not balanced justice and some senior people in very exalted positions have got away Scott-free! There is, of course, a very fine line between reckless incompetence and fraudulent behaviour.

I am still dramatically worried about the European banking sector. The sector is short of €300 billion of fresh capital required. Deutsche is a problem with a heavy balance sheet weighting in derivatives and capital markets. Deutsche has had problems lightening their book and selling assets. However, whatever Merkel says about bail-outs, ‘hell has a better chance of freezing over’ than Deutsche Bank not beating the hangman, if matters became dire. I think Andrew Bailey has done a brilliant job in regulating the UK banks and though the capital requirements are penal the banks are in better shape in the UK than they are in Europe, though RBS remains an on-going carbuncle that needs lancing, but will eventually recover. Low interest rates have not helped the banks’ cause, but a zero rate policy and QE have been essential. However that all said, the UK banking sector in terms of profitability has performed worse that US, Japan and EU thanks to the dire state of RBS huge PPI payments proportionately to much associated with Lloyds and on-going individual issues with HSBC, Lloyds, Barclays. There may not be a non-performing loan issue with UK banks, as there is perhaps in the EU, but UK bank profitability is very poor – chart & data below provided by Panmure’s chief economist Simon French.

In closing, Brexit is a total red-herring. London is the most influential centre in Europe by far in terms of trading and M&A activity and having spent 70 years building infrastructure it is not going to be allowed to be usurped by Frankfurt, Paris, Dublin or anywhere else. Negotiations will be fierce over ‘passporting’ but good sense has to prevail, however painful. London is pre-eminent at financial services – fact. Some banks may move staff for a year or so. They will return. Why? London is where it is at. Not arrogance but fact!

Will there be another replication of the 2008 banking crisis? One hopes not. However it’s the bond market that concerns me. Is the regulation of large bond operators draconian enough?